1. Field of the Invention
The present invention relates to credit event referenced assets, and more particularly, to a credit event referenced asset and a method for managing the asset where a risk of loss of an investor's principal is minimized. The asset provides a yield to the investor for a credit term, and the investor is entitled to the principal at a maturity date of the asset. However, if a credit event occurs with respect to a reference entity, then the yield is reduced and the maturity date may be extended. Thus, the investor's risk is one of a reduced yield and an extended maturity.
2. Description of the Prior Art
A credit event referenced asset is a financial instrument that is issued by an issuer, and that is linked to a credit performance of a reference entity. The reference entity is a party other than the issuer. For example, PQR Corp. can issue a credit event referenced asset that is linked to a credit performance of Venezuela.
In a conventional credit event referenced asset arrangement, the credit event referenced asset is sold, for par value, by an issuer to an investor. The issuer pays interest to the investor so long as a defined credit event has not occurred with respect to the reference entity prior to a maturity date. Such a credit event might be, for example, the reference entity's default on a loan. If a credit event occurs prior to the maturity date, the credit event referenced asset is redeemed early. The redemption value paid by the issuer to the investor is determined by reference to the decrease in value of an obligation of the defaulting reference entity. The redemption value will be an amount less than the par value. Thus, in a conventional credit event referenced asset arrangement, the investor's return of principal is at risk.
Under current U.S. tax law, a conventional credit event referenced asset arrangement is considered a contingent payment debt, that is, a debt where an expected return on the debt is not known at the time of inception. Conventional credit event referenced assets are subject to the contingent payment debt rules as there is an event that could result in a cancellation of the obligation to pay principal. If a municipal bond issuer were to issue a bond that is deemed to be contingent payment debt, only a portion of the payments made on the bond will be tax exempt, unlike non-contingent payment debt. The portion of the return that approximates the yield on a generic tax-exempt municipal bond would be tax exempt. Any yield in excess of the allowable yield would be taxable for federal income tax purposes. As an example, if a municipal bond issuer could issue a tax exempt bond, which is a conventional credit event referenced asset, that paid interest at a rate of 7% for 5 years, and the allowable yield under the tax regulations was 4%, the additional 3% of yield would be taxable.